Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 80-C-1402 -- Frank J. McGarr, Judge.

Before Bauer and Posner, Circuit Judges, and Grant, Senior District Judge.*fn*

Author: Posner

This case involves a challenge to one feature of Illinois' method of reimbursing the costs of nursing homes that serve Medicaid patients.

In 1972 Congress passed a statute requiring every state that wanted to participate in the Medicaid program to adopt, by July 1, 1976, a plan for payment of services "on a reasonable cost related basis, as determined in accordance with methods and standards which shall be developed by the State on the basis of cost-finding methods approved and verified by the Secretary (of Health, Education and Welfare, now of Health and Human Services) ...." 42 U.S.C. § 1396a(a)(13)(E). Illinois missed the deadline but finally on December 29, 1977, submitted its proposed plan to what is now the Department of Health and Human Services. The plan went into effect two days later, on January 1, 1978, and was approved a few months later by the Secretary.

Illinois' plan bases reimbursement on both operating costs and capital costs (such as depreciation, property taxes, and rental costs), but only the method of reimbursing capital costs is at issue on this appeal. Under the plan, those costs are not determined, as one might expect, on an individual-facility basis. Rather, all the nursing homes in the state are first grouped by area and then, within each area, by the year either of construction or of latest acquisition. The median capital costs for each area-year of facilities (e.g., Chicago-1975) are then computed. A nursing home whose actual capital costs are lower than the applicable median gets the median-this is the carrot to encourage economical capital management. A nursing home whose actual capital costs exceed the applicable median gets 80 percent of the excess but in no event more than eight percent above the median. So if the median were $1 per patient, a nursing home whose actual capital costs were $1.10 would get $1.08, but a nursing home whose actual capital costs were $1.11 would also get $1.08. The 80 and eight percent limitations are the stick.

The plaintiffs do not challenge this ingenious scheme for creating incentives for the economical operation of Medicaid facilities. Their only objection is to the vintage in which the scheme placed their facility, the Edgewater Nursing Home. When they acquired it on July 28, 1977, the state's reimbursement plan was still in its formative stage. The plan ultimately adopted provided that for the purpose of classifying facilities by year of construction or latest acquisition any acquisition after July 1, 1977, would be ignored and the last acquisition before that date would be used instead. The Edgewater home had been acquired by plaintiffs' predecessors in 1972, so that the plan grouped it with facilities constructed or last acquired in 1972, when prices (and hence capital costs) of nursing homes were considerably lower than in 1977. Under the state's plan, subsequent sales of facilities classified in a particular year will raise the median for subsequent rate years, but they will never put the plaintiffs in as good a position as they would be if the Edgewater home had been classified with facilities constructed or last acquired between January 1 and June 30, 1977.

The plaintiffs brought this suit against the responsible state and federal officials seeking a declaration that the July 1, 1977, cut-off date was invalid. They argue that it violates the statute in two respects: it was not "verified" by the Secretary of Health and Human Services; in any event, it did not have a "reasonable cost related basis," so that the Secretary could not properly have approved it even if he had verified it. Both sides moved for summary judgment, the defendants successfully.

The plaintiffs emphasize the alleged unfairness of applying the cut-off date to them. They say that in acquiring the Edgewater home on July 28, 1977, they relied on the fact that state officials had given no indication that the plan submitted to the federal government would include a retroactive cut-off date, and had in fact indicated the contrary. But however great a surprise it may have been, the retroactive cut-off date could not have disappointed any reasonable expectation of these plaintiffs and so have been unfair.

When the plaintiffs acquired the nursing home on July 28, 1977, they could not have known the terms on which their capital costs would be reimbursed, because the state's plan had not yet been developed, let alone submitted to and approved by the federal government. Whatever those terms were, they would be applied retroactively to these plaintiffs. And they could have been highly unfavorable terms even without a cut-off date. The statute requires only that a plan have a reasonable cost-related basis. The plaintiffs could not have known how they would fare under so elastic a standard. New York State had prior to July 28, 1977, adopted a plan that would have been even less favorable to these plaintiffs than the Illinois plan with its retroactive cut-off date, because the New York plan based capital-costs reimbursement on net depreciated value, ignoring acquisitions altogether. See Hempstead Gen. Hosp. v. Whalen, 474 F. Supp. 398, 404 (E.D.N.Y.1979), aff'd mem., 622 F.2d 573 (2d Cir. 1980). Applied to the Edgewater home, the New York approach would have based capital-costs reimbursement not on the purchase price in 1972, but on the original cost of the home, as depreciated-presumably an even lower figure.

The plaintiffs could not have known how closely Illinois might imitate New York. They were taking a shot in the dark when they signed a lease before waiting for the Illinois plan to be formulated and adopted, and they will not be heard to complain that they were treated unfairly just because the plan turned out to be less favorable to them than they had hoped it would be.

Nevertheless, although the plaintiffs were not treated unfairly, they have standing to challenge any feature of the state's plan that violates the statute to their detriment. The defendants' counsel conceded at oral argument that every feature of the plan, including the July 1, 1977, cut-off date as applied to classify the Edgewater home with facilities constructed or last acquired in 1972, must meet the statutory requirements of (1) having a reasonable cost-related basis and (2) being verified by the Secretary of Health and Human Services. The second requirement is a backstop for the first. It is not enough that a plan have in its every particular a reasonable cost-related basis; the Secretary must verify that it does. He must require the state to submit sufficient data to enable him to determine that the plan has such a basis, and then he must make that determination. See Alabama Nursing Home Ass'n v. Harris, 617 F.2d 388, 394 (5th Cir. 1980).

Since most of the evidence showing that the various components of the Illinois plan had a reasonable cost-related basis presumably would have been submitted to the Secretary as part of the verification process, we first consider whether he in fact verified the July 1 cut-off provision. Verification is an example of informal agency decision-making. Because it does not produce the kind of tidy written record on which judicial review of formal agency action is based, the district court had to reconstruct the factual basis of the Secretary's action from affidavits of his subordinates and of the state officials with whom they dealt. See Hospital Ass'n of N. Y. State, Inc. v. Toia, 473 F. Supp. 917, 927 (S.D.N.Y.1979).

To verify that the July 1, 1977, cut-off date in the Illinois plan was reasonably cost-related, the Secretary had, we ...

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